Raising money for a business, especially small businesses or startups, can be a bit of a headache when you think about how much is needed. The two main financing options people turn to when looking for capital are debts and equity.
Though debts often connote negativity, they are extremely helpful in funding businesses and may be used alongside equity financing to raise money. Equity, on the other hand, represents a percentage of the business’ ownership sold to investors as a way of raising cash.
In this article, we’ll explore what debt and equity financing are, their types, and the insurance policies that follow their principles.
Debt financing simply means borrowing money for your business. Essentially, you sign an agreement with the lender to repay the principal amount as well as the interest. This form of financing can be gotten as loans from traditional financial institutions or bonds from the business itself, among others.
Suppose XYZ company needs capital of $50 million to buy equipment and operate; they could take out a $30 million loan from the bank and sell $20 million worth of fixed-income products like bills and bonds to make up the amount. The company would then make loan repayments over the agreed period, and depending on the type of arrangement with the investors, they may pay interest on the issued bonds.
An advantage of debt financing is that the payments are scheduled and fixed, which allows businesses to plan for it when running the business. The interests can also be written off with tax returns, which lessens the burden on the business.
Another significant advantage is that your relationship with the creditors is strictly financial, and the relationship ends once the loans are paid off unless you need to borrow again in the future. They do not influence how your business operates and they are not entitled to any shares of your profit.
Debt Financing Options
There are many types of debt financing options, some of which are:
Loans from financial institutions
Bank loans are one of the oldest and most common methods of sourcing funds for your business. They check your business plan, and financial statement, and analyze your cash flow among other requirements to determine if you qualify for a loan and by how much. The loan is then set up for a fixed term and scheduled to be repaid regularly in equal installments. However, this type of loan tends to favor large and established companies alone.
For small-scale businesses or start-ups, an alternative method is obtaining SBA-guaranteed loans from creditors. The U.S. Small Business Association works with lenders to support small businesses and startups with small and large loans. These loans work like term loans and have fixed repayment schedules that run for years.
Loans from family and friends
Businesses can also use their family and friends’ contributions to support their finances. These personal loans often come with little to no interest rates and flexible repayment terms which makes them suitable for most first-time entrepreneurs and startups.
Borrowing from those close to you also comes with some risks, most significantly, risks to your reputation. Should your business go bankrupt, would you repay them? Would they feel entitled to some rewards should the business become profitable? The absence of a detailed loan agreement could lead to misunderstandings later. So it’s advisable to have a professional contract even though it’s an informal means of raising funds.
Bonds and Debentures
Issuing bonds is another common method people turn to raise loans. They are debt certificates issued to investors as a guarantee that the company would pay back the borrowed money at an agreed date. Here, the investors may earn interest on a monthly, quarterly, or annual basis, depending on the agreement. Bonds are mostly backed by the company’s assets which are used as collateral. If the company goes under, the bondholders would have more claim over the liquified assets than shareholders and other partners.
Debentures, on the other hand, are medium to long-term loans used to fund capital-intensive projects. They are similar to bonds but are not backed by collateral. Those lending the money do so based on your reputation and creditworthiness. This method of financing business operations is great for businesses that do not have the collateral to secure a traditional loan, or businesses that are performing well and do not wish to give up any rights, profits, or ownership to investors. Debenture holders are entitled to interest, which is paid regularly until the debenture matures and the principal is paid off in a lump sum.
Lines of Credit
Business lines of credit provide business owners with a fixed amount of funds to manage their short-term expenses or day-to-day operations like buying new equipment or paying salaries. It gives businesses access to a predetermined sum of money from which they can withdraw whatever amount they need, whenever they need it. There are no early payment penalties, so businesses can repay whenever they wish to.
Lines of credit can be either secured or unsecured loans. Secured loans require collateral like accounts receivable and equipment, while unsecured loans don’t require any collateral which makes them more expensive and difficult to obtain.
Lines of credit are also a form of revolving loans, meaning you can keep reusing the loan as long as you repay it. You are also only obligated to pay interest on the amount you spend, and not the total sum.
For example, let’s say you have an urgent business need of $ 2 million, and you have $5 million in lines of credit with a 3% interest rate. You can withdraw the $ 2 million and pay the 3% interest on it alone, rather than the full $5 million.
Assuming another need arises, and you haven’t repaid the initial loan, you still have the $3 million balance to take from. When you repay the loan, it tops up the available amount. So as long as you repay what you’ve borrowed, you can continue to withdraw from the same line of credit over and over again.
Business credit cards are like the popular consumer credit cards, but with higher credit limits and business-related perks to help your business operate smoothly. This method of financing your business helps streamline all your expenses into one billing statement at the end of the billing cycle. That way, you can keep track of all business expenditures in one account, rather than having multiple external invoices you’d have to organize when preparing your accounting statements.
Business credit cards also offer extended periods of interest-free loans depending on how often you repay your bills in full. Your loans would only begin to accrue interest charges when you repay the bill in parts and carry over the balance to the next billing cycle.
Equity is simply the value of an asset. When it comes to raising capital or funds for your business expenses, equity represents the worth of the company shown by how much you sell your business shares to investors. With equity financing, you can take care of short-term and long-term business operations using your investors’ money without worrying about repaying them.
This method of financing is favorable to startups and companies looking to get professional help in managing their operations. Equity financing involves selling shares to private individuals, venture capitalists, or the general public through Initial Public Offerings (IPO), among other options.
Once shares are sold, investors have the right to offer management advice, influence company decisions, or even decide the business direction. This forfeiture of ownership rights is the key difference between equity financing and debt financing.
Despite the risk of giving up some ownership rights, a significant advantage of this financing method is that you gain expert advice if your investors are well-versed in the industry. You would also benefit from a widened professional network and, most importantly, not have to repay any amount of money they’ve invested in the company.
Equity Financing Options
There are many types of equity financing options, some of which are:
You can raise funds from family members, friends, and acquaintances who wish to support your business. They often lack the expertise or knowledge needed to contribute to the decision-making process of the business, so most of the time, they do not get involved in how the company is run. They, however, do not invest large amounts, so you’d need to get a lot of individual investors to raise a decent sum.
Angel investors are individuals or groups who invest huge sums of money in the expectation that your business would yield good returns. They often have industry experience and could offer guidance, expertise, or other forms of help to grow the business.
Angel investors often analyze the company’s potential and get involved early on. However, since their priority is the company’s profitability and expected returns, they might sell their shares if they feel the company is doing badly.
Another financing option is getting funds through venture capitalists. They are highly experienced individuals, groups, or companies that invest in companies with a competitive advantage in their industry.
They bring in funds of over $1 million and request a large share of the company. Venture capitalists also get involved in the day-to-day business activities and actively participate in directing the company’s operations to maximize their investment returns.
Venture capitalists guide the company till it goes public through the Initial Public Offering, where they then sell their shares at higher prices to recoup their investment and rake in significant profit.
Initial Public Offering
This equity financing method involves making your shares available on the stock exchange for the general public to buy into. It is a great way of raising funds from millions of potential investors in the world, and they often have limited influence on management decisions. Companies, however, undergo strict evaluations to meet SEC regulations for them to be listed on the stock exchange market.
Initial public offerings are more often the choice financing method for private businesses that are already established to a large extent and have high valuations as well as evident profitability potential. This option is used by businesses in the later stages of their development.
When to choose Debt Financing
There are many factors to consider when deciding what financing method to adopt, most especially why you need the funding, how much you need, your business standing, and how much debt you can afford. Some scenarios where it is more beneficial to adopt debt financing are:
You want full control over the company
Debt financing is the best way to raise funds if you wish to maintain ownership of the business. The lenders only receive repayments on their loan until it is fully paid off. They are not involved in business operations and do not own any shares.
You need quick access to funds
Sourcing funds via debt financing is often faster and less rigorous than other financing methods. Lenders may not extensively review and analyze your business plan and projects before giving you the money.
Depending on the debt financing option, the creditors may not necessarily be interested in the company and its possibilities, rather they give out loans as a business strategy on their end to generate cash flow and earn interest. It then makes it easier to get loans for your business.
You are a risk-taker
Debt financing comes with a lot of risks. The loans are often short-term and need to be repaid according to schedule, or you risk incurring fees or even losing your assets. Creditors may require company assets or even your personal assets as collateral, and in the event the company fails, such assets could be seized.
However, if the business becomes profitable, you only need to pay off the agreed loan and interest. The profits and returns in the long term are then yours to use as you wish.
When to choose Equity Financing
You are a startup
Startups range from ideas to early-stage businesses, and sometimes it is difficult to get loans from traditional banks and other financial institutions when there is no physical business presence or hard evidence of profitability.
In this case, equity financing works best as investors such as angel investors provide enough capital to kick-start business operations even when your startup is still in its ideation stage.
You are risk-averse
If you are not prone to taking risks, this method helps to raise money without having to put your assets as collateral. Unlike debt financing, where you may have to guarantee the loan personally, investors here bear the risk burden of their investment.
Since they buy ownership in the company, you are not obligated to refund their investment even if the business goes under. Making equity financing a suitable financing method if you don’t want the pressure of debts.
You need expertise
Running a business for the first time may be challenging if you don’t have the experience to navigate the market. Sourcing professional guidance and expertise may be difficult and expensive if the advisors do not have any stake in the business.
With equity financing options like venture capital and angel investors, businesses can get professional help and industry expertise alongside funding. Those who invest in the company are highly knowledgeable in the industry, and they get involved in the company’s management.
Debt and Equity From An Insurance Perspective
Insurance is a risk management technique that provides a policyholder with guaranteed coverage for their financial needs in exchange for premiums.
Insurance companies, like every other company, raise funds to finance their operations. They too, have to find the right mix of debt and equity financing to run smoothly. But beyond their need for financing, insurance companies offer certain policies that are linked to debt and equity.
Equity-Indexed Universal Life
This type of insurance policy is directly linked to a stock market index where policyholders can invest the cash value of their policies in an equity index account. Like equity financing, where investors own shares in a company and enjoy interests from the business’ profit, this type of policy allows policyholders to participate in shares and stocks and enjoy the benefits without the added risk of actually putting money into the market.
The equity index account, where the money is kept, pays interest according to the gains of the stock market. It is, however, more complex than other policy types and may require technical financial knowledge to reap its benefits fully.
Whole life insurance
This type of insurance policy is not directly tied to debt financing, but it can be used as a vehicle to finance your expenses and own your debts. Once you are a policyholder, you can fund your expenses by borrowing from the insurance company using your policy’s cash value as collateral. This method is fast and easy as it involves fewer checks than traditional lenders and takes a shorter approval time.
Since the insurance companies don’t ask what the loan is used for, you can spend it however you wish, and may even use it to clear off external debts like credit cards or finance some business expenses. A great advantage is that there is no pressure to repay the loan, unlike other debts.
Making the right choice
The beauty in raising capital or funds for your business operations is that you’re not limited to a single financing method. You may use a mix of debt and equity financing depending on your current business situation and your financial needs.
It is advisable to work with professional financial advisors who help analyze your financial standing, needs, and goals, so you can confidently choose what financing option or debt-to-equity ratio is best for you and your business.